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June 2, 2006

For Funds, Homeland Security Involves More Than Playing Defense

Opportunities abound outside the traditional defense sector

Investors looking for exposure to the defense sector have traditionally bought shares of big blue chip military contractors and aircraft makers. Companies like Lockheed Martin (LMT), Boeing (BA), Northrop Grumman (NOC), Raytheon (RTN) and General Dynamics (GD) can be found in many ETFs and mutual funds, including the $1.06-billion Fidelity Select Defense & Aerospace Fund (FSDAX), which is the only fund mandated specifically to buy stocks in this sector.

However, the tragic events of September 11 and ongoing wars in Iraq and Afghanistan, along with terrorist strikes in Madrid, London, Bali and the continued threat of terrorism, introduced another aspect to defense investing: homeland security. Efforts by the U.S. government and corporations to increase security and surveillance, and to prevent further terrorist strikes, created a new subsector of companies providing homeland security services. This follows the Homeland Security Act of 2002 and the establishment of a Department of Homeland Security.

While Standard & Poor's does not currently isolate 'homeland security' as a subsector, several homeland security companies fall under its coverage, mainly in the aerospace/defense and technology sectors. One example is Harris Corp. (HRS), a communication equipment company that provides products and services to the government and commercial customers. Harris recently received a one-year design contract for the secure wireless transmission system architecture of the U.S. Army's warfighter information network-tactical program.

Kenneth Leon, a telecom equipment analyst for Standard & Poor's, thinks Harris' sales, which rose 19% in fiscal 2005, will gain another 14% this year and 11% next. "This reflects our view of strong government-related product demand -- 53% of estimated total sales in fiscal 2006 -- from increased spending to support the war on terrorism, as well as improved capital spending for microwave and broadcast equipment," he said. "We believe the U.S. government will remain an important driver of future orders."

Some investment managers have taken to buying companies whose products help protect the homeland. George Schwartz, president of Schwartz Investment Counsel Inc., was early to identify "homeland security" as a legitimate investment theme. As portfolio manager of the $75-million Schwartz Value Fund (RCMFX), he currently has about 7%-8% of his assets invested in these companies. "We began studying homeland security as an investment idea about two years ago," he says. "We concluded that even after the wars in Iraq and Afghanistan wind down, homeland security will be an issue Americans will have to face for generations to come as long as terrorism remain a global threat."

Schwartz believes budgets of both the U.S. government and corporations will keep a significant allocation to homeland security initiatives, thereby solidifying revenue streams for years to come. Indeed, Harris Corp. is also a top holding in the Schwartz Value fund. "They have a very successful product called the 'Falcon-II tactical multi-band radio,' which has been used by soldiers in Iraq and Afghanistan," notes Tim Schwartz, an analyst with Schwartz Investment Counsel. "Harris dominates this niche business. While they have a few other divisions, about 65% of their sales are tied to U.S. military contracts."

Leon thinks Harris' shares, currently trading at about $45, could reach $55 in twelve months. "Our target price is further supported by our view of the company's strong public sector franchise, with recurring sales and growing orders," he adds. Leon recently upgraded the stock to a "strong buy" from a "buy." Standard & Poor's also has a "buy" recommendation on L-3 Communications (LLL), which makes electronics and communications equipment for the defense industry.

"Homeland security" includes a range of companies working in disparate areas such as scanning and detection, surveillance, biometric technology, and airport security, among others, Tim Schwartz explains. "While many large companies may have small divisions with businesses related to homeland security, we define homeland security companies as deriving a majority of their revenues from this area," he says. Consequently, homeland security stocks tend to be small-caps. "These companies operate in niche businesses and they have very unique technologies. Large-cap companies don't necessarily want to deal in niche areas." While Schwartz Value Fund can invest without regard to market-cap size, it finds the most attractively priced companies in the small- and mid-cap space. The portfolio is ranked 4 Stars by Standard & Poor's.

American Science & Engineering (ASEI) is a direct play on homeland security. "This is a very unique company," Tim Schwartz says. "They make X-ray detection and scanning equipment that is used at airports, cargo ports, border crossings and government buildings, including the White House, U.S. Capitol Building and the Supreme Court. One very successful product for them is a 'Backscatter Van X-ray System,' which can efficiently scan and detect people, buildings, vehicles, etc." George Schwartz notes that President Bush's plan for more surveillance at the U.S.-Mexican border to prevent illegal immigration could greatly benefit American Science & Engineering. With revenues of $88.3 million in fiscal 2005, the company has already booked sales of nearly $123 million through the first three quarters of fiscal 2006.

Robert Stimpson, manager of the River Oak Discovery Fund (RIVSX), also includes American Science and Engineering in his portfolio. "ASEI is by far the most pure play we have with respect to homeland security," he says. "We think ASEI's technology offers opportunities in both domestic and international markets. It can be applied to borders and cargo ports in the U.S. and also Europe." River Oak Discovery Fund, is too new to carry a Star rank from Standard & Poor's.

Some homeland security companies existed before September 11, but under the shadow of global terrorism their products and services have new applications. Other homeland security firms emerged after September 11. "You have to look at these companies on a case-by-case basis," says Tim Schwartz said. "For a company like American Science & Engineering, their scanning technology was a direct response to September 11." He notes that prior to the World Trade Center terrorist attacks, American Science & Engineering was selling at $6 per share; by the end of 2001, it was trading at $25.

However, Tim Schwartz points out that the success of many homeland security companies does not wholly depend on terrorism prevention. "These firms have products and services with wide security applications, so they would still be profitable even if the terrorist threat disappeared overnight," he says. Fargo Electronics (FRGO), which makes printers and software that personalize plastic ID cards, electronically coding them with information, is another favorite of his. "These items have been sold to both government and corporations," Tim Schwartz says. "In fact, Fargo will benefit directly from President Bush's directive requiring all federal employees to carry an ID card. [Fargo Electronics Inc. recently agreed to be acquired by a subsidiary of Assa Abloy Inc., a Swedish lockmaker.]

Other homeland security holdings in the Schwartz Value include Applied Signal Technology Inc. (APSG), a maker of reconnaissance and surveillance equipment; Mine Safety Appliances Co. (MSA), which manufactures military helmets, gas masks, and body armor; and TVI Corp. (TVIN), which supplies chemical/biological decontamination systems. River Oak Discovery Fund also holds DRS Technologies (DRS), a defense electronics company that provides technology services to the U.S. military and government intelligence agencies. Their products include radar, sensor and homeland security systems.

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